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Least Square and Regression

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Least-squares linear regression is a statistical technique that may be used to estimate the total cost at the given level

of activity (units, labor/machine hours etc.) based on past cost data. It mathematically fits a straight cost line over a

scatter-chart of a number of activity and total-cost pairs in such a way that the sum of squares of the vertical

distances between the scattered points and the cost line is minimized. The term least-squares regression implies that

the ideal fitting of the regression line is achieved by minimizing the sum of squares of the distances between the

straight line and all the points on the graph.

Assuming that the cost varies along y-axis and activity levels along x-axis, the required cost line may be represented

in the form of following equation:

y = a + bx

In the above equation, a is the y-intercept of the line and it equals the approximate fixed cost at any level of activity.

Whereas b is the slope of the line and it equals the average variable cost per unit of activity.

Formulas

By using mathematical techniques beyond the scope of this article, the following formulas to calculate a and bmay be

derived:

Unit Variable Costbnxyxynx2x2

Total Fixed Costaybxn

Where,

n is number of pairs of unitstotal-cost used in the calculation;

y is the sum of total costs of all data pairs;

x is the sum of units of all data pairs;

xy is the sum of the products of cost and units of all data pairs; and

x2 is the sum of squares of units of all data pairs.

The following example based on the same data as in high-low method tries to illustrate the usage of least squares

linear regression method to split a mixed cost into its fixed and variable components:

Example

Based on the following data of number of units produced and the corresponding total cost, estimate the total cost of

producing 4,000 units. Use the least-squares linear regression method.

Month

Units

Cost

1

2

3

4

5

6

7

8

1,520

1,250

1,750

1,600

2,350

2,100

3,000

2,750

$36,375

38,000

41,750

42,360

55,080

48,100

59,000

56,800

Solution:

x

1,520

1,250

1,750

1,600

2,350

2,100

3,000

2,750

16,320

We have,

n = 8;

x2

y

$36,375

38,000

41,750

42,360

55,080

48,100

59,000

56,800

377,465

2,310,400

1,562,500

3,062,500

2,560,000

5,522,500

4,410,000

9,000,000

7,562,500

35,990,400

xy

3,511,808,000

1,953,125,000

5,359,375,000

4,096,000,000

12,977,875,000

9,261,000,000

27,000,000,000

20,796,875,000

84,956,058,000

x = 16,320;

y = 377,465;

x2 = 35,990,400; and

xy = 84,956,058,000

Calculating the average variable cost per unit:

b884,956,058,00016,320377,465835,990,40016,320213.8

Calculating the approximate total fixed cost:

a377,46513.807816,320819,015

The cost-volume formula now becomes:

y = 19,015 + 13.8x

At 4,000 activity level, the estimated total cost is $74,215 [= 19,015 + 13.8 4,000].

High-Low Method

High-Low method is one of the several techniques used to split a mixed cost into its fixed and variable components

(see cost classifications). Although easy to understand, high low method is relatively unreliable. This is because it only

takes two extreme activity levels (i.e. labor hours, machine hours, etc.) from a set of actual data of various activity

levels and their corresponding total cost figures. These figures are then used to calculate the approximate variable

cost per unit (b) and total fixed cost (a) to obtain a cost volume formula:

y = a + bx

Variable Cost per Unit

Variable cost per unit (b) is calculated using the following formula:

y2 y1

Variable Cost per Unit =

x2 x1

Where,

y2 is the total cost at highest level of activity;

y1 is the total cost at lowest level of activity;

x2 are the number of units/labor hours etc. at highest level of activity; and

x1 are the number of units/labor hours etc. at lowest level of activity

The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost change in number of

units produced).

Total fixed cost (a) is calculated by subtracting total variable cost from total cost, thus:

Example

Company wants to determine the cost-volume relation between its factory overhead cost and number of units

produced. Use the high-low method to split its factory overhead (FOH) costs into fixed and variable components and

create a cost volume formula. The volume and the corresponding total cost information of the factory for past eight

months are given below:

Month

Units

FOH

1,520

$36,375

1,250

38,000

1,750

41,750

1,600

42,360

2,350

55,080

2,100

48,100

3,000

59,000

2,750

56,800

Solution:

We have,

at highest activity: x2 = 3,000; y2 = $59,000

at lowest activity: x1 = 1,250; y1 = $38,000

Variable Cost per Unit = ($59,000 $38,000) (3,000 1,250) = $12 per unit

Total Fixed Cost = $59,000 ($12 3,000) = $38,000 ($12 1,250) = $23,000

Cost Volume Formula: y = $23,000 + 12x

Due to its unreliability, high low method is rarely used. The other techniques of variable and fixed cost estimation are

scatter-graph method and least-squares regression method.

Break-even is the point of zero loss or profit. At break-even point, the revenues of the business are equal its total

costs and its contribution margin equals its total fixed costs. Break-even point can be calculated by equation

method, contribution method or graphical method. The equation method is based on the cost-volume-profit

(CVP) formula:

px = vx + FC + Profit

Where,

p is the price per unit,

x is the number of units,

v is variable cost per unit and

FC is total fixed cost.

Calculation

At break-even point the profit is zero therefore the CVP formula is simplified to:

px = vx + FC

Solving the above equation for x which equals break-even point in sales units, we get:

FC

Break-even Sales Units = x =

pv

Break-even point in number of sales dollars is calculated using the following formula:

Example

Calculate break-even point in sales units and sales dollars from following information:

$15

Total Fixed Cost

$7

$9,000

Solution

We have,

p = $15

v = $7, and

FC = $9,000

Substituting the known values into the formula for breakeven point in sales units, we get:

Breakeven Point in Sales Units (x)

= 9,000 (15 7)

= 9,000 8

= 1,125 units

Break-even Point in Sales Dollars = $15 1,125 = $16,875

Sales mix is the proportion in which two or more products are sold. For the calculation of break-even point for sales

mix, following assumptions are made in addition to those already made for CVP analysis:

1.

2.

The sales mix must not change within the relevant time period.

The calculation method for the break-even point of sales mix is based on the contribution approach method. Since we

have multiple products in sales mix therefore it is most likely that we will be dealing with products with different

contribution margin per unit and contribution margin ratios. This problem is overcome by calculating weighted average

contribution margin per unit and contribution margin ratio. These are then used to calculate the break-even point for

sales mix.

The calculation procedure and the formulas are discussed via following example:

Following information is related to sales mix of product A, B and C.

Product

$15

$21

$36

$9

$14

$19

20%

20%

60%

$40,000

Calculation

Step 1: Calculate the contribution margin per unit for each product:

Product

$15

$21

$36

$9

$14

$19

$6

$7

$17

Step 2: Calculate the weighted-average contribution margin per unit for the sales mix using the following formula:

Product A CM per Unit Product A Sales Mix Percentage

+ Product B CM per Unit Product B Sales Mix Percentage

+ Product C CM per Unit Product C Sales Mix Percentage

= Weighted Average Unit Contribution Margin

Product

$15

$21

$36

$9

$14

$19

$6

$7

$17

20%

20%

60%

$1.2

$1.4

$10.2

$12.80

Step 3: Calculate total units of sales mix required to break-even using the formula:

Break-even Point in Units of Sales Mix = Total Fixed Cost Weighted Average CM per Unit

Weighted Average CM per Unit

$40,000

$12.80

3,125

Product

Sales Mix Ratio

Total Break-even Units

Product Units at Break-even Point

20%

20%

60%

3,125

3,125

3,125

625

625

1,875

Product

625

625

1,875

$15

$21

$36

$9,375

$13,125

$67,500

Sum: Break-even Point in Dollars

$90,000

Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash

inflows generated by the investment. It is one of the simplest investment appraisal techniques.

Formula

The formula to calculate payback period of a project depends on whether the cash flow per period from the project is

even or uneven. In case they are even, the formula to calculate payback period is:

Payback Period =

Initial Investment

Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the

following formula for payback period:

Payback Period = A +

In the above formula,

A is the last period with a negative cumulative cash flow;

B is the absolute value of cumulative cash flow at the end of the period A;

C is the total cash flow during the period after A

Both of the above situations are applied in the following examples.

Decision Rule

Accept the project only if its payback period is LESS than the target payback period.

Examples

B

C

Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to

generate $25 million per year for 7 years. Calculate the payback period of the project.

Solution

Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million and is expected to

generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in

Year 5. Calculate the payback value of the project.

Solution

(cash flows in

Cumulative

millions)

Cash Flow

Year

Cash Flow

0

(50)

(50)

1

10

(40)

2

13

(27)

3

16

(11)

4

19

8

5

22

30

Payback Period

= 3 + (|-$11M| $19M)

= 3 + ($11M $19M)

3 + 0.58

3.58 years

Advantages of payback period are:

1.

2.

It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are

considered more uncertain, payback period provides an indication of how certain the project cash inflows are.

3.

For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

1.

Payback period does not take into account the time value of money which is a serious drawback since it can

lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted

payback period method.

2.

It does not take into account, the cash flows that occur after the payback period.

One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this

limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value

of money by discounting the cash inflows of the project.

In discounted payback period we have to calculate the present value of each cash inflow taking the start of the first

period as zero point. For this purpose the management has to set a suitable discount rate. The discounted cash inflow

for each period is to be calculated using the formula:

(1 + i)n

Where,

i is the discount rate;

n is the period to which the cash inflow relates.

Usually the above formula is split into two components which are actual cash inflow and present value factor ( i.e. 1 /

( 1 + i )^n ). Thus discounted cash flow is the product of actual cash flow and present value factor.

The rest of the procedure is similar to the calculation of simple payback period except that we have to use the

discounted cash flows as calculated above instead of actual cash flows. The cumulative cash flow will be replaced by

cumulative discounted cash flow.

Where,

A = Last period with a negative discounted cumulative cash flow;

B = Absolute value of discounted cumulative cash flow at the end of the period A;

C = Discounted cash flow during the period after A.

Note: In the calculation of simple payback period, we could use an alternative formula for situations where all the cash

inflows were even. That formula won't be applicable here since it is extremely unlikely that discounted cash inflows

will be even.

The calculation method is illustrated in the example below.

Decision Rule

If the discounted payback period is less that the target period, accept the project. Otherwise reject.

Example

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted

payback period of the investment if the discount rate is 11%.

Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by

present value factor. Create a cumulative discounted cash flow column.

Year

n

Cash Flow

CF

PV$1=1/(1+i)n

Discounted Cash

Flow

CFPV$1

Cumulative Discounted

Cash Flow

$

2,324,000

1.0000

$ 2,324,000

$ 2,324,000

600,000

0.9009

540,541

1,783,459

600,000

0.8116

486,973

1,296,486

600,000

0.7312

438,715

857,771

600,000

0.6587

395,239

462,533

600,000

0.5935

356,071

106,462

600,000

0.5346

320,785

214,323

Advantage: Discounted payback period is more reliable than simple payback period since it accounts for time value of

money. It is interesting to note that if a project has negative net present value it won't pay back the initial investment.

Disadvantage: It ignores the cash inflows from project after the payback period.

Written by Irfanullah Jan

Sales Budget

Sales budget is the first and basic component ofmaster budget and it shows the expected number of sales units of a

period and the expected price per unit. It also shows total sales which are simply the product of expected sales units

and expected price per unit.

Sales Budget influences many of the other components of master budget either directly or indirectly. This is due to the

reason that the total sales figure provided by sales budget is used as a base figure in other component budgets. For

example the schedule of receipts from customers, the production budget, pro forma income statement, etc.

Due to the fact that many components of master budget rely on sales budget, the estimated sales volume and price

must be forecasted with sufficient care and only reliable forecast techniques should be employed. Otherwise the

master budget will be rendered ineffective for planning and control.

Where the price per unit is expected to remain constant during the period for all units in sales, the sales budget

format will be simple as shown below.

Company A

Sales Budget

For the Year Ending December 30, 2010

Quarter

1

Sales Units

Price per Unit

Total Sales

Year

1,320

954

1,103

1,766

$91

$92

$97

$112

$120,120

$87,768

$106,991

$197,792

5,143

$512,671

However if a business sells more than one product having different prices or the price per unit is expected to change

during the period, its sales budget will be detailed.

Written by Irfanullah Jan

Production Budget

Production budget is a schedule showing planned production in units which must be made by a manufacturer during a

specific period to meet the expected demand for sales and the planned finished goods inventory. The required

production is determined by subtracting the beginning finished goods inventory from the sum of expected sales and

planned ending inventory of the period. Thus:

Planned Produciton in Units

= Expected Sales in Units

+ Planned Ending Inventory in Units

Begining Inventory in Units

Production budget is prepared after sales budgetsince it needs the expected sales units figure which is provided by the

sales budget. It is important to note that only a manufacturing business needs to prepare the production budget.

The following example illustrates the production budget format. The expected sales units are obtained from the sales

budget of Company A. The planned ending units of 1st, 2nd and 3rd period are the beginning units in 2nd, 3rd and

4th period respectively.

Company A

Production Budget

For the Year Ending December 30, 2010

Quarter

1

Budgeted Sales Units

Year

1,320

954

1,103

1,766

5,143

210

168

213

225

225

Beginning Units

196

210

168

213

196

1,334

912

1,148

1,778

5,172

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